Introduction

Today the Luxembourg Parliament approved the bill n° 6497
modifying the Luxembourg Income Tax Act ("LIR") in
certain areas, some of which will impact the private equity
industry. This legal alert will focus on certain specific points
impacting this industry.

Avoiding the retirement cliff

Public deficit or surplus is the difference between government
receipts and government spending in a single year. Running a
country with a constant public deficit is almost universal in the
21st century. The 2007-2009 financial crisis led to a dramatic
increase in the public deficits of many advanced economies, with
many of them experiencing their highest levels of debt since World
War II. Presented as a percent of gross domestic product (GDP),
total deficit for OECD countries went from -1.2% of total OECD GDP
in 2006 to -6.6% in 2011. Some countries have had rather severe
deficits over the last few years, including, for 2011, a -10%
deficit in the United States and -9.4% in the UK. Economic
powerhouses such as the United States and the UK may well be able
to deal with the additional government debt resulting from those
deficits. Even so, the recent ongoing discussions regarding the
risks of the U.S. economy tumbling off the fiscal cliff - with $600
billion in tax increases and spending cuts - show that even the
largest economies may not continuously run public deficits without
getting punished at some moment in time.

Luxembourg, as a tiny country, though seen as punching above its
weight, has always considered it necessary to avoid putting itself
into positions similar to those of competitors such as Ireland and
Cyprus who run a -10.3% deficit and -6.3% respectively, seemingly
without really attempting to address the state of their public
finances. With an expected public deficit of -1.5% for 2013, and an
expected public debt of broadly 20% of GDP (compared to the Irish
public debt of 120% and the Cyprus debt of 60.8%), Luxembourg
appears to be top of the class. Nonetheless, the government has
decided to cut back on expenses by some €538 million and to
increase the tax receipts by €414 million approximately, in
order to reduce the public deficit to approximately 0.8% of
GDP.

The reason for these policy measures has nothing to do with
concerns such as those encountered in Ireland where the cost of
servicing public debt is moving towards 20% of tax revenues. That
cost in Luxembourg is well below 1%. However, as is the case for
any other country, Luxembourg needs to solve the pension puzzle.
Indeed, reforming pensions is one of the biggest challenges of the
21st century. All OECD countries have to adjust to the ageing of
their populations and re-balance retirement income provision to
keep it adequate and ensure that the system is financially
sustainable. Luxembourg has decided to tackle this issue in its
2052 Agenda by trying to ensure that the presently healthy State
pension system remains in good shape throughout that period. This
has led to several changes to the State pension system taking
effect in 2013. Ensuring, through a careful running of the annual
budgets, that surpluses rather than deficits are being generated,
the Luxembourg government further seeks to prevent public debt from
ever becoming a burden for the next generation. Quite simply, it
does not seem right to the Luxembourg policy makers for the
government to use debt to provide extra consumption for the older
generation, and then subsequently tax the younger generation to
repay the debt. By scaling back expenses for 2012, by temporarily
increasing the tax rates for individuals, by introducing a new
minimum tax for all the businesses, and by increasing the already
existing minimum tax for certain businesses, the Luxembourg
government seeks to place Luxembourg public finances on a healthy
footing for years to come.

The alternative minimum tax constrained by
international law

In 2011, Luxembourg Parliament introduced a minimum corporate
tax (the "alternative minimum tax" or "AMT")
for certain Luxembourg corporations ("Financial Luxcos"),
being those entities whose assets consist almost entirely (> 90%
of the total balance-sheet) of financial assets (loans,
participations, cash at bank etc.). This amount has now been
increased with effect for 2013 to 3,000 €. At the same time,
Luxembourg Parliament has decided to also introduce for the other
corporate taxpayers ("Other Luxcos") an AMT ranging from
500 € to 20,000 € depending upon the total balance-sheet
of the respective Luxco (the cap of 20,000 € will be reached
as of a total balance-sheet of 20,000,000 €).

Applying the above rules to private equity Luxcos, the expected
tax liability (assuming the actual taxable income does not already
lead to a higher tax) would normally be as follows:

1. Luxcos holding targets for a future sale: 3,000 €

2. Luxcos providing debt financing to group companies: 3,000
€ (although the margin taxation would in most cases anyway
lead to a higher amount of tax)

The above rules may however lead to unintended consequences
which may be illustrated with two examples.

Let us take the example of a Financial Luxco essentially holding
financial assets. The Financial Luxco was subject, as of 2011, to
an annual tax of 1,500 €. In its 2011 version, the minimum tax
of 1,500 € was still viewed as a toll charge aiming at
compensating the enrolment and annual administrative costs incurred
by the tax authorities when dealing with companies not paying any
income tax in Luxembourg, mainly because all of their income was
exempt under the participation exemption regime. By doubling the
minimum tax to 3,000 € however, it would no longer be possible
to consider the AMT as mere compensation for costs incurred by the
Luxembourg tax authorities when processing the file. The AMT
essentially turns into an alternative minimum income tax. However,
in doing so, new issues consequently arise. Indeed, a Financial
Luxco may generate only dividend income which is tax-exempt under a
specific tax treaty or under the EU Parent-Subsidiary Directive. By
levying the AMT, Luxembourg in fact taxes income that should be
tax-exempt under a tax treaty or EU law. It hence commits a treaty
override, which is not possible under Luxembourg law, or an EU
override, which is equally prohibited under EU law, if it levies
the AMT in those circumstances.

A similar comment may be made as regards certain Other Luxcos,
being those that mainly hold real estate in a tax treaty
jurisdiction. With sixty-four tax treaties presently in force, and
some twenty pending, the bulk of real estate investments any Other
Luxco would conceivably wish to consider buying would be located in
tax treaty countries. Under any tax treaty entered into by
Luxembourg, the net rental income as well as the capital gain upon
disposal of the real estate may only be taxed in the source
country, hence by the tax authorities of the treaty partner.
Subjecting these entities as Other Luxcos to an alternative minimum
income tax of 20,000 € effectively leads to a taxation of real
estate income in situations where the relevant tax treaty does not
grant any taxing rights to Luxembourg.

The alternative minimum tax should only apply to income
over which Luxembourg has retained the right to tax, though in
reality it does also tax Luxco, even if its income is exempt as a
result of international law

The COFIBU (the Commission of Finance and Budget of the
Parliament), which is the special commission of Parliament dealing
with budget matters, when reviewing the draft bill, expressly
stated that the AMT should not be due in circumstances where
Luxembourg no longer has the right to tax the income under tax
treaty law or EU law.

However, this position does not appear to be reflected under
applicable statute provisions. Indeed, an additional paragraph was
added by the COFIBU to article 2 of the final version of the draft
bill amending paragraph 6 of article 174 LIR, ostensibly in order
to deal with this point. This additional paragraph however only
states that "the minimum tax is to be viewed as an advance
corporation income tax payment for future years, to the extent it
exceeds the tax calculated for the year. As an exception to article
154 § 7 LIR (which provides the condition under which an
excess tax is to be repaid to the taxpayer), the minimum tax may
not get reimbursed to the taxpayer". The apparent consequence
of this provision, which has been copied from the Austrian Income
Tax Code, is to reserve the right of the tax authorities to levy
the AMT, even in those circumstances where all of the income is
exempt from tax under international law. Indeed, the AMT would not
directly tax income that is exempt under international law; it
would rather constitute an advance payment on Luxco's future
tax liability. That tax liability may not be known yet, but is
expected according to the Income Tax Act to arise sooner or later
as a result of future taxable income. Since the income that is
exempt under international law is not taxable, either this year, or
in any subsequent year, the advance payment of income tax
implicitly but necessarily refers to other sources of income that
Luxco may have in due course.

In reality, this is nothing but a disguised though very real
taxation of income Luxembourg simply cannot tax. Take for instance
the example of a Luxco property company which holds one single
asset in a treaty country. Any income Luxco would realise, be it
the initial rental income or the subsequent capital upon disposal
of the real estate, may only be taxed under the treaty in the
source country. As the Luxco has no other taxable income, and, for
the sake of argument, is being liquidated upon sale of the real
estate, there is simply no room for levying the AMT. Doing so
should be seen in due course as being a breach of the relevant
provisions of the tax treaty and hence should lead the tax courts
to rule in favor of a refund of the AMT. There, of course, exists
no guarantee on the matter, since being in court is always a little
like being in open sea, without a rudder or compass, but at the
very least the chances of success in case of litigation are real
and not just purely hypothetical.

Conclusion

The AMT is an unfortunate step taken by the government which
appears to have been ill advised, not only on what is at stake, but
also as regards its technical merits. Given the international
nature of Luxco's activities, the levying of the AMT would more
often than not lead to treaty and EU law overrides. It would have
been far better, had the Luxembourg Parliament given itself further
time to reflect rather than rushing ill-drafted legislation through
the approval process.

The content of this article is intended to provide a general
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